Chapter Outline,8.1 Corporate Strategy and Positive NPV 8.2 Decision Trees 8.3 Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis 8.4 Options 8.5 Summary and Conclusions,Introduce new products Apple Corporation and the mouse Develop core technology Honda and small engines Create barrier to entry Qualcomms patents on proprietary technology Introduce variations on existing products Chryslers PT Cruiser Create product differentiation Coca-Colaits the real thing Utilize organizational innovation Motorola just-in-time inventory management Exploit a new technology Yahoo!s use of banner advertisements on the web,Corporate Strategy and Positive NPV,Corporate Strategy and the Stock Market,There should be a connection between the stock market and capital budgeting. If the firm invests in a positive NPV projects, the firms stock price should go up. Sometimes the stock market provides negative clues as to a new projects NPV. Consider AT&Ts repeated attempts to penetrate the computer-manufacturing industry.,8.2 Decision Trees,Allow us to graphically represent the alternatives available to us in each period and the likely consequences of our actions.,Example of Decision Tree,Do not study,Study finance,Open circles represent decisions to be made.,Filled circles represent receipt of information e.g. a test score in this class.,The lines leading away from the circles represent the alternatives.,Stewart Pharmaceuticals,The Stewart Pharmaceuticals Corporation is considering investing in developing a drug that cures the common cold. A corporate planning group, including representatives from production, marketing, and engineering, has recommended that the firm go ahead with the test and development phase. This preliminary phase will last one year and cost $1billion. Furthermore, the group believes that there is a 60% chance that tests will prove successful. If the initial tests are successful, Stewart Pharmaceuticals can go ahead with full-scale production. This investment phase will cost $1,600 million. Production will occur over the next 4 years.,Stewart Pharmaceuticals NPV of Full-Scale Production following Successful Test,Note that the NPV is calculated as of date 1, the date at which the investment of $1,600 million is made. Later we bring this number back to date 0.,Decision Tree for Stewart Pharmaceutical,Do not test,Test,Failure,Success,Do not invest,Invest,The firm has two decisions to make:,To test or not to test.,To invest or not to invest.,Stewart Pharmaceutical: Decision to Test,Lets move back to the first stage, where the decision boils down to the simple question: should we invest? The expected payoff evaluated at date 1 is:,The NPV evaluated at date 0 is:,So we should test.,8.3 Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis,Allows us to look the behind the NPV number to see firm our estimates are. When working with spreadsheets, try to build your model so that you can just adjust variables in one cell and have the NPV calculations key to that.,Sensitivity Analysis and Scenario Analysis,In the Stewart Pharmaceutical example, revenues were projected to be $7,000,000 per year. If they are only $6,000,000 per year, the NPV falls to $1,341.64,Also known as “what if” analysis; we examine how sensitive a particular NPV calculation is to changes in the underlying assumptions.,Sensitivity Analysis,We can see that NPV is very sensitive to changes in revenues. For example, a 14% drop in revenue leads to a 61% drop in NPV,For every 1% drop in revenue we can expect roughly a 4.25% drop in NPV,Scenario Analysis,A variation on sensitivity analysis is scenario analysis. For example, the following three scenarios could apply to Stewart Pharmaceuticals: The next years each have heavy cold seasons, and sales exceed expectations, but labor costs skyrocket. The next years are normal and sales meet expectations. The next years each have lighter than normal cold seasons, so sales fail to meet expectations. Other scenarios could apply to FDA approval for their drug. For each scenario, calculate the NPV.,Break-Even Analysis,Another way to examine variability in our forecasts is break-even analysis. In the Stewart Pharmaceuticals example, we could be concerned with break-even revenue, break-even sales volume or break-even price. The break-even IATCF is given by:,Break-Even Analysis,We can start with the break-even incremental after-tax cash flow and work backwards through the income statement to back out break-even revenue:,Break-Even Analysis,Now that we have break-even revenue as $5,358.72 million we can calculate break-even price and sales volume. If the original plan was to generate revenues of $7,000 million by selling the cold cure at $10 per dose and selling 700 million doses per year, we can reach break-even revenue with a sales volume of only:,We can reach break-even revenue with a price of only:,8.4 Options,One of the fundamental insights of modern finan